Good thoughts – One naive question: How do you keep this business out of your books? Surely, it would show on the balance sheet if a professional auditor checked it out. Cash and bank balances are about as easy to audit as anything. Assets and liabilities up by equal amounts. – If insignificant in the big picture, so what? If significant it would be reported, is’nt it? Help me!

I found this post timely as just earlier today I was having a discussion with a friend who happened to be an accountant for a not so small company in Beijing. In talking with her, she described one of the reasons she chose to leave China and come to the US to pursue her accounting career was her realization that much of the accounting in China was “fake.” I have heard similar perceptions from some other Chinese friends, and I am always amazed that they don’t skip a beat when describing how books are cooked, how keeping two sets of books are common place, etc. They have really bought into the “its just how things are done” mantra.

There are legitimate reasons for companies to invest in real estate and in loans to other companies. One thing that industrial companies provide for their workers are apartments and living quarters, because the cost of real estate is so high that they won’t be able to get any workers without providing housing, and every factory above a certain size that I’ve ever seen in China has had dormitories attached to them.
Also it’s very common for large companies to provide loans to their suppliers because without those loans, their suppliers can’t get credit to produce the goods that the suppliers have.
In the case of companies that are listed in US/HK, all of this is legally required to be in the accounting statements which are audited by international auditing agencies, and you can look at the balance sheets to see the amount of real estate and lending. Now you may distrust the auditors (after all they didn’t catch Enron), but that’s another issue.
Also, aggregate statements about Chinese companies aren’t that useful. Chinese SOE’s are structured so that you have a few mega-enterprises and a few thousand smaller ones. You have differences between those that are centrally owned, those are that provincially and locally owned. Most SOE’s aren’t listed in the market, and the one’s that are are a small fraction of SOE’s. So statements like X% of SOE’s are Y aren’t that useful.
One final thing about the Chinese stock market, one has to realize that the market is policy driven. Most of the companies in Shanghai are government owned, and the Chinese government can set the stock market index to be whatever it wants to be, by buying and selling shares.
Harris: I strongly suspect that most publicly traded Chinese companies that have engaged in this practice did not list it on their books.
I strongly suspect otherwise for companies that are listed in the United States since for all of the problems that the SEC has, I don’t think they they are that clueless, and what you saying is highly illegal under US law. I also don’t think that any US auditor would let a Chinese company get away with this after what happened with Arthur Andersen and Enron.
What is more likely is that these loans *are* listed in the disclosure statements, but most people buying stock don’t read the fine print. If you look at the balance sheet for any large publicly traded Chinese company, they *do* list property holdings and loans in their balance sheets.

@ Jeff “how keeping two sets of books are common place”
While there are other issues in there, keeping multiple sets of books keeps the tax bill low. Given Chinese enterprises pay through the roof for licenses, social insurances, turnover and corporate taxes, the gap between the official and unofficial books is their profit and about the only thing keeping them afloat.
Onto the real estate issue, Dan is spot on in identifying the on lending practices (not just SOEs but also many large private corporations and SMEs that have had access to bank loans). Failures in these lending chains will have cascading effects that will drag many good enterprises under. A good business making machinery (where margins are tight and competition intense) borrows lots of money to lend to a real estate developer. The gap between the official and unofficial interest rates, makes the machinery businesses margins and profitability look much better. Then the developer implodes and it pulls the machinery business down with it.
These lending chains run across whole swathes of Chinese industry. When asset prices were bubbling, it was all very nice and improved the profitability of large numbers of enterprises. When the bubble bursts it will pull some down and force those still viable to fund the mess out of their not-so-profitable ordinary business.

Chris: While there are other issues in there, keeping multiple sets of books keeps the tax bill low. Given Chinese enterprises pay through the roof for licenses, social insurances, turnover and corporate taxes, the gap between the official and unofficial books is their profit and about the only thing keeping them afloat.
On the other hand, from a financial stability point of view, this is a good thing. It means that the “official books” understate the actual profitability of the corporation, and that the company in fact has more money than what the books say.
There’s a point of view that says that the news is always worse than what you see, but sometimes “bad is good.” For example, the fact that people in China will evade taxes means that you have a ton of income and assets that are unreported.
I think China is moving to the US system where companies keep three sets of books but all of this happens “above the table” rather than “under the table.” There are three types of accounting. Tax accounting, financial accounting, and management accounting, and you end up with different numbers. People keep books under the table because the rules are often unreasonable, but the trend in China is to make the rules more reasonable so that things become more transparent.
Chris: The gap between the official and unofficial interest rates, makes the machinery businesses margins and profitability look much better. Then the developer implodes and it pulls the machinery business down with it.
On the other hand if the company is lending money to its suppliers then this in fact improves things. It means that when things go bad, the business can decide whether to save or dump the supply chain.
Chris: These lending chains run across whole swathes of Chinese industry. When asset prices were bubbling, it was all very nice and improved the profitability of large numbers of enterprises.
It’s actually a much, much deeper problem. The problem is that there are very few sources of “above the table” credit so Chinese business have to rely on “under the table” financing to get things done. Informal lending chains are an essential part of the Chinese economy. It’s not merely a matter of “cooking the books”. Without informal financing, large parts of the Chinese economy just could not function. Banks will loan only to SOE’s. Friends and family will work only for relatively small businesses. If you have an SME, you need informal financing just to run the business.
However, “informal” doesn’t mean “bad.” One reason I’m optimistic that this won’t be the end of the world, is that China has gone through several boom/bust cycles before, and I see nothing different about this cycle. Something that’s good about “informal lending” is that you in fact often have fewer moral hazard problems. If you loan money informally, and it goes bad, you absorb the loss, and if you are a net lender rather than a net borrower, then you have enough reserves to keep the dominoes from falling. In some situations, informal lenders are in fact much more careful about who they lend money to, and how much than formal lenders.
Chris: When the bubble bursts it will pull some down and force those still viable to fund the mess out of their not-so-profitable ordinary business.
The bubble is bursting as we speak. One thing that the government has decided to do is to let the bubble burst now. Something about the Chinese economy is that it “feels” less crazy now than it did earlier this year.
And this will continue until you start having unemployment and the threat of protests at which point the government will start flooding the system with credit, and which point the cycle will start all over again.
One reason I’m not totally alarmed by all of this is that it’s all part of the credit cycle. Having a real estate (and stock market) crash in China is like having a hurricane in Florida or an snowstorm in New England. It happens with such regularity that you can set your watch with it.
If someone can explain to me why this market crash is different than the five or six ones we’ve already gone through over the last 20 years, I’d be interested.

I’m a little late to this discussion, but I would just add one point. Sometimes, the investment in real estate is the whole point of the manufacturing operation. That is to say, SMEs started in manufacturing operations as a vehicle to obtain capital/connections/concessions and enter into the real estate market. Low margin manufacturers considered moving into real estate as a “step up the value chain,” especially in the boom since 2003. That said, I don’t think a lot of those SMEs are listed overseas.
As for the stock market, anyone casually buying/selling Chinese companies is asking for trouble. The amount of serious due diligence that is required to make an informed investment is, in my opinion, substantially higher than what is needed to invest in developed market companies. I’d be hesitant to invest in any Chinese company without a site visit at the very least, and that’s not something that I can afford to do (or pay someone to do) as an individual investor. However, I don’t feel like I need to visit GE or Apple (just examples) to make an educated decision on a stock purchase. I’d be interested to hear someone make a case for individuals investing directly in Chinese stocks (rather than through a mutual fund or ETF), however. Perhaps an open thread?